[EN] Netflix business model is fundamentally broken

Netflix stock has given back nearly 20% of its value in the last month, and, despite the company’s overall good performance in terms of subscriber additions, the case is strong that it continues to be an overvalued portfolio pick at its current price of $355/share.

As 2013 made clear for the company, margin compression, fierce competition and high content costs are all continuing bugabears for the online streaming giant, whose underlying financial fundamentals are actually in decline.

Those bugabears are even now “hindering the already unrealistic profit growth priced into Netflix's stock,” said David Trainer, a stock analyst at New Constructs, in a Seeking Alpha blog. “In November of last year, Netflix landed in the Danger Zone after rising 363% year-to-date on promising quarterly results and much media hype. While 2013 was a positive year for Netflix in some respects… more evidence mounts that the NFLX business model is fundamentally broken.”

And the business model is not just a little cracked, but actually more like busted. The short story is this: Netflix is seeing decreasing returns on capital as its costs rise.

To justify its current [share price], NFLX would need to achieve[after-tax profits (NOPAT)] margins of 6.2% and grow NOPAT by 25% compounded annually for the next 16 years,” Trainer explained. “In short, NFLX would need to almost double its current margins in this highly competitive space while growing NOPAT at a consistently exceptional rate. These expectations are clearly inconsistent with the realities that NFLX's margins are falling, not rising, and that growth is slowing - not accelerating.”

Now for the details: In 2013, Netflix grew NOPAT from $33 million to $148 million, and grew its NOPAT margins from 1% to just over 3%. In addition, Netflix's return on invested capital (ROIC) rose from 2% to 7%. It sounds great on paper—and Trainer pointed out that in general, this would be excellent performance for most companies. But consider that in 2009, Netflix earned a NOPAT of $119 million. That means that over the past five years NFLX has grown NOPAT by just $29 million,or just 4% compounded annually.

“This slow profit growth is largely due to two factors: rising content costs and the decline of Netflix's high-margin DVD rental service,” Trainer said. In fact, in its 2013 annual report,the company revealed that the total value of NFLX's obligations for streaming content has surpassed its annual revenue.

Its content costs have risen from $3.9 billion in 2011 to $7.3 billion last year. Amortization expenses on Netflix's streaming library are following suit and grew $699 million to $2.1 billion over the same period.

So, over the past two years, the company's revenues have grown by 17% compounded annually, while its costs have grown by 23% compounded annually.

“Netflix is in constant content-bidding wars with a number of other big name companies such as Amazon, Apple, Google andOuterwall,” Trainer said. “As a result, the costs of its large and frequently updated content library are rising quickly.”

Many investors — and Netflix itself — have pointed to its ongoing international expansion as the saving grace for the company.Netflix's international subscriber base grew by an impressive 79% in 2013, and there’s clearly much room for growth, but the same cost and pitfalls outlined above are not exclusive to Netflix's U.S. operations.

“Netflix admits in its filing that international expansion holds similar and additional costs as its domestic services, including: (1) accounting for alternative payment methods, (2) adapting to foreign intellectual property and licensing structures and (3) foreign tastes not matching up with domestic products that Netflix has already paid to license internationally,” Trainer said.“Lack of widespread broadband service and the marketing costs to build a subscriber base from zero will also drag down international margins initially. Indeed, Netflix admits that losses in the international segment are substantial as the firm drives membership growth from zero.”

There are other issues too, such as the glut of competing services. “Netflix is merely a delivery platform, hardly unique anymore,” Trainer said. “The company has many competitors now, many of whom are much better competitively positioned…Even a few unknown developers from Argentina can whip up a similar delivery service as a project.”

And adding insult to injury is the slow death of its domestic DVD segment—which is ironically highly profitable. Netflix say a 56% decline in membership for the DVD-by-mail service in 2013.

“While a decline in this business segment is hardly surprising considering both the increased competition of OUTR and the convenience of Netflix's streaming services, it is financially damaging as Netflix's DVD rental service has operating margins approaching 50%,” Trainer explained.

In short, Netflix could be a good buy for short-term investment, but looking at the long haul, the company is in trouble, Trainer said. “Investors seem to have missed the memo that the company's profit margins will be permanently lower,” said Trainer. “It's time for investors to get out while they still can.When this stock still had positive momentum investors might have overlooked its flaws, but now that the momentum is gone NFLX represents an attractive short opportunity.”

Netflix to spend $3bn on TV and film content in 2014

Netflix is committed to spending almost $3bn on TV and film content in 2014 and more than $6bn over the next three years, as the cost of securing international rights and commissioning new shows continues to mount on the streaming giant's balance sheet.

The US company also announced this week that it is to raise $400m to help fund this investment in original programming and a major European expansion later this year.

Its annual report, published this week, shows that at the end of 2013, Netflix had run up $7.3bn in "streaming content obligations", which are incurred when the company signs a licence agreement for programming, up 30% from the $5.6bn owed at the end of 2012.

The company said it has to pay $2.97bn of that by the end of 2014, with a total of $6.2bn due within three years.

Netflix made $4.3bn in total revenues last year, a healthy 19% year-on-year rise, growth which has made it a darling of US stock market investors, with its share price surging from $92 to $367 across 2013.

However, total "cost of revenues", of which licensing costs are the major factor, also rose 17% from $2.6bn to $3.1bn.

With another $500m ploughed into marketing, $378m into technology development and $180m in "general and administrative expenses", the US company ended the year with net profits of $112m.

The US movie and TV streaming giant, which is expected to expand into Germany and France later this year, said that it expects to "substantially increase" investment in shows that it makes itself, such as House Of Cards and Orange is the New Black.

"We expect to significantly increase our investments in international expansion, including substantial expansion in Europe in 2014, and in original content," the company said in a Securities & Exchange Commission filing. "As a result, and to take advantage of the current favourable interest rate environment, we plan to obtain approximately $400m in long-term debt in the first quarter."

Netflix has been able to build its business by snapping up relatively cheap streaming rights, the potential value of which had been largely unrecognised by rivals and rights owners.

However, as Netflix has prospered and expanded its operational internationally and faced more competition from video-on-demand rivals, the value of securing these rights has mounted.

Netflix pointed out that despite planning a major increase in its original content budget, it would still represent less than 10% of the company's overall global content expenditure on rights to stream TV and films.

In a press statement, the company added that some of the $400m could also be earmarked for "potential acquisitions and strategic transactions".

Netflix's international expansion is becoming increasingly important to the company's growth plans.

The company's international subscriber base grew by 1.7 million to 10.93 million in the final quarter last year. Across 2013, Netflix put on 4.8 million new international subscribers in total, an 80% year-on-year increase.

Its international operations made $712m in revenue last year, up 148% year on year.

The international operation continues to make a loss, $274m in 2013, although this was a 30% year-on-year reduction.

Netflix launched its first streaming operation outside the US in 2010, when it expanded to Canada.

Latin America followed in 2011, the UK and Ireland in early 2012, and Scandinavia later the same year. The Netherlands is Netflix's latest market, launched in September last year.

Netflix: Avoid At All Cost

By David Trainer | Stock Markets | Apr 02, 2014

In November of last year, Netflix Inc. landed in the Danger Zone after rising 363% year-to-date on promising quarterly results and much media hype. The stock rose rapidly for a while after our pick but has come back down nearly 20% in the past month.

Early last month, Netflix filed their annual 10-K, allowing us to update our model with its most recent financial data. While 2013 was a positive year for Netflix in some respects, many of the concerns in my November article were confirmed. Margin compression, fierce competition and high content costs are all hindering the already unrealistic profit growth priced into Netflix’s stock. Our original sell/short thesis is proving true as more evidence mounts that the NFLX business model is fundamentally broken.

Underlying Fundamentals Are In Decline

After Netflix’s rocky 2012, it was easy for the company to improve its performance in 2013. Netflix grew after-tax profits (NOPAT) from $33 million to $148 million, and grew its NOPAT margins from 1% to just over 3%. In addition, Netflix’s return on invested capital (ROIC) rose from 2% to 7%.

In general, this would be excellent performance for most companies, but considering Netflix’s track record before 2012 and its current valuation, the company is underperforming. In 2009, Netflix earned a NOPAT of $119 million. That means over the past five years NFLX has grown NOPAT by just $29 million, or just 4% compounded annually. This slow profit growth is largely due to two factors: rising content costs and the decline of Netflix’s high-margin DVD rental service.

Business Model is Busted

Judging by Netflix’s 2013 annual report, it does not look like either of these trends will reverse in the future. Figure 1 shows how the total value of NFLX’s obligations for streaming content has surpassed its annual revenue.

Netflix is seeing decreasing returns on capital as its costs rise. Since 2009, Netflix’s revenues have grown by 27% compounded annually while its costs of revenue have grown by 30% compounded annually. This disparity increases as the timeframe grows shorter: over the past two years, the company’s revenues have grown by 17% compounded annually, while its costs have grown by 23% compounded annually.

These rapidly increasing costs are primarily due to the licensing fees required to maintain Netflix’s expansive streaming content library. Netflix is in constant content-bidding wars with a number of other big name companies such as Amazon.com Inc., Apple Inc., Google Inc., and Outerwall. As a result, the costs of its large and frequently updated content library are rising quickly. To illustrate, streaming content obligations ballooned from $3.9 billion in 2011 to $7.3 billion in 2013. Amortization expenses on Netflix’s streaming library are following suit and grew $699 million to $2.1 billion over the same period.

Last November, we predicted that Netflix’s bottom line would find itself in trouble as costs rise because creating original content and hosting a content library are extremely expensive. Netflix is merely a delivery platform, hardly unique anymore. The company has many competitors now, many of whom are much better competitively positioned. For example, Amazon.com just announced a streaming television and music service in the same vein. Even a few unknown developers from Argentina can whip up a similar delivery service as a project.

Moreover, NFLX’s domestic DVD segment experienced membership losses of 56% in 2013, compared to a 26% decline from 2011 to 2012. While a decline in this business segment is hardly surprising considering both the increased competition of OUTR and the convenience of Netflix’s streaming services, it is financially damaging as Netflix’s DVD rental service has operating margins approaching 50%.

The decline of Netflix’s highly profitable DVD segment has been a drag on its previously explosive profit growth. Between 2003 and 2008, when Netflix first introduced its streaming video service, NOPAT grew by 73% compounded annually. Between 2008 and 2013, NOPAT has grown by just 14% compounded annually.

The Flawed Bull Case

Much of the Netflix bull case rests on the opportunity for international expansion. It is true that Netflix’s international subscriber base grew by an impressive 79%, and it is also true that there is presently much room for growth here. However, the same cost and pitfalls I have described above are not exclusive to Netflix’s U.S. operations, and additional hidden costs exist in expanding to international markets.

Netflix admits in its filing that international expansion holds similar and additional costs as its domestic services, including: (1) accounting for alternative payment methods, (2) adapting to foreign intellectual property and licensing structures and (3) foreign tastes not matching up with domestic products that Netflix has already paid to license internationally. Lack of widespread broadband service and the marketing costs to build a subscriber base from zero will also drag down international margins initially. Indeed, Netflix admits that losses in the international segment are substantial as the firm drives membership growth from zero.

Valuation is Approaching the Stratosphere

While the above factors have put the brakes on Netflix’s profit growth, investors seem to have missed the memo that the company’s profit margins will be permanently lower. To justify its current price of ~$355/share, NFLX would need to achieve NOPAT margins of 6.2% and grow NOPAT by 25% compounded annually for the next 16 years. In short, NFLX would need to almost double its current margins in this highly competitive space while growing NOPAT at a consistently exceptional rate. These expectations are clearly inconsistent with the realities that NFLX’s margins are falling, not rising, and that growth is slowing — not accelerating.

Recent declines in the stock suggest the market is just starting to catch on to the reality of the company’s situation, but I would emphasize the phrase “just starting.” The stock still has much farther to fall. The company provides a great service at a reasonable price, but investors need look no further than 2011’s Qwikster spin-off and subscriber exodus to see what kind of effect price hikes have on Netflix’s business.

Netflix shares dropped 20% in March alone. It’s time for investors to get out while they still can. When this stock still had positive momentum investors might have overlooked its flaws, but now that the momentum is gone NFLX represents an attractive short opportunity.

Insiders Selling

Although NFLX has had quite the run-up in the past year, executives have apparently decided that it’s time to get off the train – and quickly. In the past six months, insiders have sold off over one million shares, or 45% of their holdings. If this level of dumping does not serve as a warning to investors, I am not sure what will.

André Rouillard contributed to this report.

Disclosure: David Trainer is short NFLX. David Trainer and André Rouillard receive no compensation to write about any specific stock, sector, or theme.

Pay-TV subs rise despite online alternatives

The number of homes worldwide paying to watch television continues to rise, despite a popular view that people are turning to online alternatives, according to the latest quarterly Multiscreen Index published by consultancy firm informitv.

The report shows an overall increase in the digital subscriber numbers of 100 leading pay-television services around the world, across the board, by region or mode of delivery.

The greatest growth is in developing regions but even established markets such as the United States show annual and quarterly gains.

Services delivered by satellite, cable and telephone lines are all gaining subscribers, with telco providers among the leaders.

Sixty per cent of pay-TV services in the Index now deliver to multiple screens other than a traditional television, including smartphones, tablets and other network-connected devices.

“Pay-TV providers are launching multiscreen offerings to head off competition from new online subscription video services,” says Dr William Cooper, the founder and chief executive of informitv. “Our research reveals that there is an increasing trend towards delivering services to multiple screens, from smartphones to smart televisions. Contrary to popular opinion that television subscriptions are in decline, the informitv Multiscreen Index presents a bigger picture that shows the total number of pay-TV subscriptions is increasing, particularly in developing markets.”

The 100 multichannel pay-TV services in the Multiscreen Index cover over 30 countries and generally each has more than a million digital television subscribers. They collectively represent around 320 million subscribing homes worldwide.

In 2013, the Multiscreen Index saw a net gain of 18.98 million subscribers, an increase of 6.3 per cent. In the last quarter, the ten services in the Index reporting the largest subscriber gains added 2.97 million video customers or 5.6 per cent. The ten reporting the largest losses collectively lost 0.48 million video customers in three months, a combined loss of 1.7 per cent.

In the United States, which is the largest pay-TV market by value, cable companies have been losing subscribers while satellite and telco providers have gained customers, and the overall trend is that digital television services are growing. The top six pay-TV providers added 9.44 million digital television subscribers over the last seven years, led by the advance of telco television.

The Asia Pacific region shows the greatest growth, up 1.63 million subscribers in the last quarter, without counting major operators in China and India that do not disclose subscriber numbers. There is also substantial growth in Latin America, Russia and Eastern Europe.

The Multiscreen Index tracks trends in television services and provides an accessible compilation of top ten tables showing annual and quarterly changes in subscriber numbers. The figures are based exclusively on the most recent customer data provided by operators rather analyst estimates. The latest issue includes subscriber numbers to the end of 2013.

IHS: Professional video market grows 52%

The next wave of expansion through 2017 is expected to be driven by the provision of media-managed services, particularly those involving the transport, processing and management of digital content. By 2017, the managed service segment will grow to $32 billion, accounting for nearly half of the expected $69 billion total for the professional video market.

Culminating a dramatic six-year period of growth, the global market for professional broadcast equipment and services reached $63 billion in 2013, up 52 per cent from $41 billion in 2007, according to findings from the IHS Technology Professional Video Research practice.

The rapid growth has been driven by a significant rise in shipments of customer-premises equipment (CPE) fuelled by the digitisation of pay TV subscribers. The market’s expansion also has been propelled by a rise in transport services, driven by an increasing number of linear channels and non-linear views by consumers.

While the factors that have powered the growth of the market are expected to remain in force through 2017, total spending on equipment is expected to slow significantly. Many core markets in North America, Western Europe and East Asia are facing slower CPE shipment growth.

The next wave of expansion through 2017 is expected to be driven by the provision of media-managed services, particularly those involving the transport, processing and management of digital content. By 2017, the managed service segment will grow to $32 billion, accounting for nearly half of the expected $69 billion total for the professional video market.

Tom Morrod, senior director for Consumer Electronics and Video Technology at IHS, said that with the multitude of broadcasters and pay-TV operators in each country, there was a very diverse market of small to medium companies offering solutions in the industry. “As a greater share of industry revenue shifts toward services, we’re also seeing new entrants from the information technology, telecommunications and equipment industries trying to capture some of the new video service revenue,” he explained.

In all, the top 10 professional video vendors accounted for 28 per cent of all market revenue in 2013.

The leading provider in 2013 was Cisco, with involvement in varied sectors such as conditional access, set-top boxes, encoders, Internet Protocol and optical equipment and systems integration.

Other major players tend have a primary focus on a single market segment, such as transport, set-top boxes or broadband CPE. These more specialised players include Arris/Motorola, Pace, SES, EchoStar and Samsung. The one notable exception is Sony, which has large ventures in two areas: the professional camera and the storage/server industries.

North America remained the dominant professional video market in 2013, but it is heavily dependent on CPE shipments, which are expected to decelerate in the region until 2017. Because of this, Asia-Pacific in 2017 will become the largest single market for broadcast technology, driven by growth in services, particularly surrounding satellite, fibre and teleport transport of increasing digital channels and content.

The other major market, Western Europe, is expected to maintain stable revenues, as an increase in outsourced processing and transport services is balanced by a decline in the value of CPE and content capture equipment.